Fin 464

Chapter 2: The Impact of Government Policy and Regulation

Banking Regulation• Governments around the world have created a complex regulatory environment

for financial-service firms in an effort to:▫ Safeguard the public’s savings or interests▫ Bring stability to the financial system▫ Prevent abuse of financial-service customers

• Financial institutions must contend with some of the heaviest and most comprehensive rules applied to any industry

The quality of loans, investments and the adequacy of capital are carefully reviewed by government examiners.

• Regulation for the financial institution can be ▫ Burdensome▫ Costly▫ Damaging to innovation and efficiency

• In the United States, banks are regulated through a dual banking system▫ Both federal and state authorities have significant regulatory powers

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Reasons for the Regulation of Banks1) Protection of the safety of the Public’s Savings from misuse, fraud,

mismanagement, embezzlement as banks are the leading repositories of savings 2) Evaluate the true conditions of bank as savers lack financial expertise required to

evaluate the riskiness of a bank3) Promote Public Confidence in the financial system so that savings flow

smoothly into productivity investment , and payments made speedily and efficiently.

4) Control the supply of Money and Credit as it is correlated with economic conditions

bank has power to create money and this changes in volume influence unemployment and inflation in the society.

5) Ensure Equal Opportunity and Fairness in access to credit and other financial services; eliminate discrimination in terms age, sex, race, national origin

6) Help for Segments of the Economy that have special credit needs7) Avoid Concentration of Power8) Support of Government Activities like credit, tax revenues & other services

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The Central Banking System• The central bank of the United States is the Federal Reserve System (the Fed)

• A central bank’s primary job is monetary policy▫ Influence the supply and cost of money and credit in order to ensure

economic growth at an adequate rate, low unemployment and inflation, and currency stability.

• Central Bank’s other fundamental functions: ▫ Provide and maintain an effective and efficient payments▫ Supervise and regulate depository institutions operations▫ Sets reserve requirement on deposits held by depository institutions ▫ Clearing & collecting checks & other cash items▫ Making loans to qualified depository institutions

• The Fed or European Central Bank is free to pursue these goals because it does not depend on the government for its funding▫ Central banks in Asia such as Bank of Japan, People’s Bank of China are

under close control of their government

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The Central Banking System: Its Impact on the Decisions & Policies if

Individual Banks Monetary Policy: Control over money, credit &

interest rates to achieve a nation’s economic goals. The policy has two basic goals:

1. To promote “maximum” sustainable output & employment. &

2. To promote “stability” in price level.

Major Banking Laws1. National Currency and Bank Acts (1863–64) These laws set up a system for chartering new national banks through a newly created bureau inside the U.S. Treasury Department, the Office of the Comptroller of the Currency (OCC). The Comptroller not only assesses the need for and charters new national banks but also regularly examines those institutions.2. The Federal Reserve Act (1913) Creation of the Federal Reserve System (the Fed). The Fed’s principal roles are to serve as a lender of last resort and to help stabilize the financial markets and the economy. Their most important job today is to control money and credit conditions to promote economic stability.3. The Banking Act of 1933 (Glass-Steagall)The Glass-Steagall Act defined the boundaries of commercial banking by providing constraints that were effective for more than 60 years. This legislation separated commercial banking from investment banking and insurance. The Federal Deposit Insurance Corporation (FDIC) was created to guarantee the public’s deposits up to a stipulated maximum amount in order to enhance public confidence in the banking system. Initially $2,500 and today it is up to $250,000

Major Banking Laws (contd..)

3. The FDIC Improvement Act (1991) This legislation permitted the FDIC to additional borrow from the Treasury to remain solvent, and implemented new deposit insurance premiums differentiated on the basis of risk, and defined the actions to be taken when depository institutions did not meet capital requirements. Prior to 1993, the FDIC imposed fixed insurance premiums on all deposits eligible for insurance coverage, regardless of the riskiness of an individual depository institution’s balance sheet.

4. Dodd-Frank Regulatory Reform Act of 2010 (FINREG)Insurance limit was push to $250,000 for all categories of deposits.

Major Banking Laws (contd..)

5. The Riegle-Neal Interstate Banking Law (1994) Repealed previous provisions that prevented full-service interstate banking nationwide . Adequately capitalized and managed holding companies can acquire banks anywhere in the United States. Interstate holding companies may consolidate their affiliated banks acquired across state lines into full-service branch offices. No single banking company can control more than 10 percent of nationwide deposits or more than 30 percent of deposits in a single state (unless a state waives this latter restriction)6. The Financial Services Modernization Act (The Gramm-Leach-Bliley Act (1999) )

▫ Overturned long-standing provisions of the Glass-Steagall Act and the Bank Holding Company Act

▫ Permitted banking companies to affiliate with insurance and securities firms under common ownership

▫ Securities and insurance companies could form financial holding companies (FHC) that control one or more banks

▫ Banks were permitted to sell insurance and security services, provided they conform to state and federal rules

▫ This law’s purpose was to allow qualified U.S. financial-service companies to diversify their service offerings and reduce their overall business risk exposure

Major Banking Laws (contd..)

7. The USA Patriot Act▫ Passed originally in 1970 to combat money laundering▫ Requires that financial-service providers establish the identity of

customers opening new accounts or holding accounts whose terms are changed

▫ Usually accomplished by asking for a driver’s license or other acceptable picture ID and obtaining the social security number of the customer

▫ Service providers are required to check the customer’s ID against a government-supplied list of terrorist organizations and report any suspicious activity in a customer’s account

8. The Sarbanes-Oxley Accounting Standards Act (2002)

It requires publicly owned companies to strengthen their auditing practices and prohibits publishing the false or misleading information about the financial condition.

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The Central Bank’s Principal Task: Making & Implementing Monetary

Policy1. The Open Market Operations Policy (OMO):

To reduce the money supply in the economy, Central bank sells securities in the open market.

To increase the money supply, Central bank repurchase the securities sold earlier from the market.

2. The Discount Rate Policy: Discount rate is the rate at which the central bank lends money to the scheduled banks or discounts the bills of the commercial banks.

To reduce the money supply in the economy, Central bank raises the discount rate.

To increase the money supply in the economy, Central bank reduces the discount rate.

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The Central Bank’s Principal Task: Making & Implementing Monetary Policy----Contd

3. Changing Reserve Requirements on Deposits & other Bank Liabilities:

Raising reserve requirements, banks must set aside more of each incoming deposits into required reserves, & less money is available to support making new loans.

Lowering reserve requirement, releases reserves for additional bank lending.

{What are bank reserves?

Banks and other depository institutions (for convenience, we'll refer to all of these as "banks") keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. In fact, banks are required to hold a certain amount in reserves. But, typically, they hold even more than they're required to in order to clear overnight checks, restock ATMs, and make other payments. }

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The Central Bank’s Principal Task: Making & Implementing Monetary Policy----Contd

4. Other Policy Tools:

a) Moral Suasion: The Central bank tries to bring psychological pressure to bear on individuals & institutions to conform the bank’s policies, using telephone calls or letters to bankers, making speeches explaining the Central bank’s policies, & testifying before parliament to explain what the CB is doing & to clarify it.

b) Margin Requirements: An investor buying certain listed securities must use his or her own funds to cover a specified percentage of the securities’ purchase price, the rest of that price may be borrowed, using the purchased securities as collateral.

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Impact of Fiscal Policy on Banks Increases in government spending usually lead to increase in

business & households incomes, which increases both bank deposit & loan demand, eventually accelerating the pacer of economic activity - & perhaps inflation as well.

Increases in government spending must be financed by added government borrowing, the tendency is to push interest rates higher as government credit demands are added to private credit demands, placing banks under increased pressure to meet all of their customers’ funding needs.

Decisions by parliament to raise taxes & reduce budget deficits normally lead to decreases in Treasury borrowings & eventually push interest rates lower. Private sector incomes, bank deposits, & loan demand are also likely to fall.

Prudential Regulations of Bangladesh Bank (updated till January,

2014)1. Policy On Capital Adequacy Of Banks 2. Policy On Loan Classification And Provisioning3. Policy On Single Borrower Exposure4. Policy For Rescheduling Of Loans5. Policy For Loan Write Off6. Corporate Governance In Bank Management7. Constitution Of The Board Of Directors And Fit And Proper Test For

Appointment Of Bank Directors8. Constitution Of The Executive Committee, Audit Committee and Risk

management Committee Of Board Of Directors

Prudential Regulations of Bangladesh Bank (contd.)

9. Rules and Regulations For Appointment Of Chief Executive and Advisor In Banks

10. Restriction On Lending To Directors Of Private Banks11. Interest Rates On Deposit And Lending12. Bank Charges13. Guidelines On Managing Core Risks In Banking14. Credit Rating15. Disclosure Requirements For Banks16. Bank Deposit Insurance Scheme